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Policy Hub: Macroblog provides concise commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues for a broad audience.

Authors for Policy Hub: Macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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January 7, 2009

Will tax stimulus stimulate investment?

Update: Reader Doug Lee points out that the fixed investment series above is dominated by the extraordinary decline in residential investment over the past several years. For that sector, the questions posed above are in a bit sharper focus. Are firms in the residential investment sector pessimistic about future prospects? Absolutely. Are compromised credit markets behind the low investment levels? Quite possibly, though given the large inventory overhang in housing it is improbable that activity in the sector would be robust in any case. Is the low investment/net worth ratio symptomatic of a general deleveraging within the nonfinancial business sector? Not so clear, as it is pretty hard to see through the effect in residential category.

Here, then is a chart of the history of nonresidential fixed investment relative to corporate net worth:


The recent decline in the ratio, while still there, is much less dramatic and, in fact, seems to be part of a more persistent trend that commenced prior to the 2001 recession (and which may have been temporarily disguised by the housing boom that followed).

Was the nonfinancial nonresidential business sector ahead in the deleveraging game—ahead of residential construction businesses, financial firms, and consumers? And could this bode well for this sector when the recovery begins? Unfortunately, I have more questions than answers.

By David Altig, senior vice president and research director at the Atlanta Fed

Original post:

On Monday, the form of potential fiscal stimulus, 2009-style, took a step forward detail-wise. From the Wall Street Journal:

“President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses, a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs.

“The size of the proposed tax cuts—which would account for about 40% of a stimulus package that could reach $775 billion over two years—is greater than many on both sides of the aisle in Congress had anticipated.”

The plan appears to make concessions to both economic theory—which suggests that consumers will save a relatively large fraction of temporary increases in disposable income—and recent experience—which seems to suggest that what works in theory sometimes works in practice. Again, from the Wall Street Journal:

“Economists of all political stripes widely agree the checks sent out last spring were ineffective in stemming the economic slide, partly because many strapped consumers paid bills or saved the cash rather than spend it. But Obama aides wanted a provision that could get money into consumers’ hands fast, and hope they will be persuaded to spend money this time if the credit is made a permanent feature of the tax code.”

As for the business tax package:

“… a key provision would allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years. Obama aides note that businesses would have been able to claim most of the tax write-offs on future tax returns, and the proposal simply accelerates those write-offs to make them available in the current tax season, when a lack of available credit is leaving many companies short of cash.

“A second provision would entice firms to plow that money back into new investment. The write-offs would be retroactive to expenditures made as of Jan. 1, 2009, to ensure that companies don’t sit on their money until after Congress passes the measure.”

A relevant question here is really quite similar to the one we ask when the tax cuts are aimed at households: Will the extra cash be spent? This graph provides some interesting perspective:


Relative to net worth (of nonfarm nonfinancial corporate businesses), private fixed investment has been in consistent decline since the second quarter of 2006. (The level of fixed investment has declined in each quarter, save one.) In fact, the investment/net worth ratio is currently at a postwar low.

Why? A couple of hypotheses come to mind. (1) Firms are extremely pessimistic about the outlook and see relatively few worthwhile projects in which to commit funds. (2) Credit markets are so impaired that the net worth of firms—a critical variable in mainstream models of the so-called “credit channel” of monetary policy—is supporting increasingly smaller levels of lending. (3) Nonfinancial firms, like financial firms, are deleveraging and hence not expanding.

Of course, even if one of these hypotheses is true, it need not be the case that marginal dollars sent in the direction of businesses will go uninvested. But it makes you wonder.

By David Altig, senior vice president and research director at the Atlanta Fed

December 10, 2008

Credit storm hitting the high seas?

Now that the mystery has been solved concerning whether we are in recession or not, our attention can turn to monitoring the conditions that might signal the contraction’s end. A nice assist in this endeavor comes from the “Credit Crisis Watch” at The Big Picture, which includes an extensive list of graphs summarizing ongoing conditions in credit markets.

In case that list is not extensive enough for you, allow us to add one more item to the list: the condition of trade finance. International trade amounts to about $14 trillion and, according to the World Trade Organization (WTO), 90 percent of these transactions involve trade financing. Trade-related credit is issued primarily by banks via “letters of credit,” the purpose of which is to secure payment for the exporter. Letters of credit prove that a business is able to pay and allow exporters to load cargo for shipments with the assurance of being paid. Though routine in normal times, the letter of credit of process is yet another example of how transactions between multiple financial intermediaries introduce counterparty risk and the potential for trouble when confidence flags.

This is how it works: Company A located in the Republic of A wants to buy goods from Company B located in B-land. Company A and B draw up a sales contract for the agreed sales price of $100,000. Company A would then go to its bank, A Plus Bank, and apply for a letter of credit for $100,000 with Company B as the beneficiary. (The letter of credit is done either through a standard loan underwriting process or funded with a deposit and an associated fee). A Plus Bank sends a copy of the letter of credit to B Bank, which notifies Company B that its payment is available when the terms and conditions of the letter of credit have been met (normally upon receipt of shipping documents). Once the documents have been confirmed, A Plus Bank transfers the $100,000 to Bank B to be credited to Company B.

Letter of Credit Process

In general, exporters and importers in emerging economies may be particularly vulnerable since they rely more heavily on trade finance, and in recent weeks, the price of credit has risen significantly, especially for emerging economies. According to Bloomberg, the cost of a letter of credit has tripled for importers in China, Brazil, and Turkey and doubled for Pakistan, Argentina, and Bangladesh. Banks are now charging 1.5 percent of the value of the transaction for credit guarantees for some Chinese transactions. There have been reports of banks refusing to honor letters of credit from other banks and cargo ships being stranded at ports, according to Dismal Scientist.

These financial market woes are clearly spilling over to “global Main Street.” The Baltic Dry Index, an indirect gauge of international trade flows, has dropped by more than 90 percent since its peak in June as a result not only of decreased global demand but also availability of financing that demand, according to Dismal Scientist.

Baltic Dry Index

In the words of the WTO’s Director-General Pascal Lamy, “The world economy is slowing and we are seeing trade decrease. If trade finance is not tackled, we run the risk of further exacerbating this downward spiral.” Since about 40 percent of U.S. exports are shipped to developing countries, the inability of the importers in those countries to finance their purchases of U.S.-made goods can’t help the U.S. exports sector, which is already suffering from falling foreign demand as the global economy slows.

At VoxEU, Helmut Reisen sums up the situation thus:

“As a mid-term consequence of the global credit crisis, private debt will be financed only reluctantly and capital costs are bound to rise to incorporate higher risk. Instead, solvent governments and public institutions will become the lenders of last resort.”

That process has begun. In the last 12 months, according to the WTO, export credit agencies have increased their business by more than 30 percent, with an acceleration since the summer. The increase in this activity, the WTO reports, is being backed by governments of some of the world’s largest exporters, such as Germany and Japan.

Most recently, to support exports of products from the United States and China to emerging economies, both countries decided on December 5 to provide a total of $20 billion through their export-import banks. The program will be implemented in the form of direct loans, guarantees, or insurance to creditworthy banks. Together, the United  States and China expect that these efforts will generate total trade financing for up to $38 billion in exports over the next year.

The sense one gets from The Big Picture charts is that at least some hopeful signs have emerged in developed-economy credit markets. Going forward, progress in markets directly related to trade flows between developed and emerging economies may well be an equally key indicator of how quickly we turn the bend toward recovery.

By Galina Alexeenko and Sandra Kollen, senior economic research analysts at the Federal Reserve Bank of Atlanta

October 30, 2008

MMMF, and AMLF, and MMIFF. Part 2 of a 2-part Series

On Tuesday we left off with a promise to do a post focusing on the Fed’s Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) and Money Money Market Investor Funding Facility (MMIFF). We’re making good on that promise. Whereas the Commercial Paper Funding Facility (CPFF) was targeted primarily at issuers of commercial paper and intended to improve market conditions for businesses that rely on the CP market to finance themselves, both the AMLF and MMIFF are targeted at money market funds (MMFs) and helping them meet escalating redemption requests.

A Bloomberg article by Christopher Condon and Bryan Keogh does a nice job of describing the circumstances immediately preceding the creation of the AMLF:

While money funds were selling commercial paper in the past few months, the exodus accelerated after the bankruptcy of Lehman Brothers Holdings Inc. on Sept. 15 and the breakdown of the nation's oldest money-market fund the next day.”

“The $62.5 billion Reserve Primary Fund announced Sept. 16 that losses on debt issued by Lehman had reduced its net assets to 97 cents a share, making it the first money fund in 14 years to break the buck, the term for falling below the $1 a share that investors pay. Over the next two days, investors pulled $133 billion from U.S. money-market funds, according to IMoneyNet.” (emphasis added)

As has been publicized, the large withdrawals from money market funds were not without consequence. MMFs provide a link between investors looking to earn a return on their money and businesses looking to sell their short-term debt. A break in the link can lead to reduced business activity and pose risks to economic growth.

Conditions in the commercial paper market had already been under stress prior to the Reserve Primary Fund’s losses. Weak demand for CP and the massive outflows from MMFs forced some funds to sell the paper in an illiquid market—leading in some cases to losses, something that isn’t supposed to happen in MMFs.

Compounding the issues in the CP market was a reallocation of MMFs’ portfolios toward safer Treasury securities. In addition to the desire of MMFs to shed CP and other assets to meet redemptions, MMFs have been reallocating their assets toward safer, more liquid, Treasuries. MMFs were not alone. The general flight to safety among investors is immediately recognizable in the large drop in Treasury yields (particularly on shorter-dated securities) since Sept 15.

Commercial Paper Outstanding

The MMF outflows slowed after the Treasury announced on Sept 19 they would temporarily guarantee money market funds (on amounts held at the close on Sept 19), and after the Fed announced the AMLF on the same day.

The AMLF provides nonrecourse loans at the primary credit rate to U.S. depository institutions, bank holding companies, or U.S. branches and agencies of foreign banks. They can then use the loans to purchase eligible A-1/P-1/F-1 ABCP at amortized cost from MMFs. A bank that borrows under the program is at no risk for loss as credit risk is effectively transferred to the Fed. The chart below shows rates on 1, 2, and 3-month ABCP and the primary credit rate and can give an idea of what kind of spread a bank can earn through arbitrage (borrowing at the discount window and purchasing ABCP). So, if a MMF experiences redemptions, it can sell its ABCP to a bank without taking a loss and a bank can make a profit by earning the spread between the discount window rate and the rate on purchased ABCP. A secondary effect is that by reducing risk associated with lack of liquidity in the secondary market for CP, the AMLF provides an incentive for MMFs to resume their purchases of ABCP from issuers.

Commercial Paper Outstanding

AMLF borrowing from the Fed to finance ABCP purchases from MMF has grown markedly from $73 billion on Sept 24 to $108 billion on Oct 22. To compare, discount window lending, which has reached record levels, rose from $39 billion to $108 billion over the same period.

Commercial Paper Outstanding

To complement the AMLF, the Fed announced on Oct 21 the creation of the MMIFF which will provide funding up to $540 billion in financing to purchase U.S. dollar-denominated certificates of deposit (CDs), bank notes, and CP. Similar to the AMLF, the MMIFFF will support MMFs in meeting redemptions by purchasing assets which might otherwise need to be sold in an illiquid market. It differs from the AMLF primarily because it’s targeted at purchasing a broader set of assets, including unsecured CP. The MMIFF differs from the CPFF in that it aims to help money market funds rather than issuers of CP.

While the MMIFF start date is still being determined, the NY Fed provides a series of helpful FAQs explaining how the program will work.

Recovery in MMF and CP markets may be a significant factor in restoring normalcy to credit markets and should have broader, positive impacts. The Federal Reserve Board states: “Improved money market conditions will enhance the ability of banks and other financial intermediaries to accommodate the credit needs of businesses and households.”

Today’s Fed release showing the first increase in CP outstanding since mid-Sept is a good sign.

By Mike Hammill and Andrew Flowers in the Federal Reserve Bank of Atlanta’s Research Department.

October 28, 2008

The Commercial Paper Market and the Fed’s Commercial Paper Funding Facility: Part 1 of a 2-part Series

The current financial crisis is a good reminder of how interconnected our financial system really is. The financial tsunami has engulfed seemingly unconnected and obscure corners of the credit market, making them front of mind for a general public that had probably never heard of them before (think SIVs, auction rate securities, monoline insurers, credit default swaps, variable rate demand notes, commercial paper, etc).

Recently, we have heard a lot [here, here, and here] about the issues in the very important but relatively unglamorous commercial paper market. Commercial paper (CP) is a short-term debt instrument issued by large banks and corporations with a maturity of one to 270 days.

Traditionally, companies use CP to finance day-to-day operations, borrowing cash they need to meet payroll or buy materials. Borrowing short-term money gives a company more flexibility to meet short-term needs, and is usually cheaper than issuing long-term debt. Companies can, and often do, roll over their CP as it matures, which effectively turns short-term debt into long-term debt, but at short-term interest rates.

In the past few years the commercial-paper market has grown dramatically, increasing by about 56 percent from 2005 until its peak in August 2007. Much of this growth has been in asset-backed commercial paper (ABCP), which jumped 76 percent over the same period. [Here is the Board’s most recent CP report.] In contrast to unsecured CP, which is backed by the name and assets of an entire company, ABCP is backed by a pool of specific assets, such as credit card debt, car loans, and/or mortgages.

Commercial Paper Outstanding

CP generally carries low risk because of its short duration. With unsecured CP, the primary risk is some negative event that threatens the viability of an issuing company's business. But for ABCP, the primary risk is a shock to the value of the underlying asset—such as higher-than-expected mortgage defaults, and an uncertain trajectory for defaults in the future. Recently, both unsecured (especially financial firms) and asset-backed (especially mortgage-backed) CP markets have come under considerable stress.

Money market funds are significant buyers of CP because it typically offers a slightly higher yield than, say, short-term Treasury securities. Money market mutual funds and other institutional investors purchase about 60 percent of commercial paper in the market, according to mutual-fund tracking firm Crane Data.

Following the failure of a number of financial institutions and increased uncertainty about the quality of assets underlying some of the asset-backed paper, the problems in the CP market intensified in September. On the one hand, the demand from money market funds declined as they were faced with a rise in redemptions. This development contributed to a sharp decline in CP outstanding (see chart above). At the same time, investors began demanding higher interest rates in order to buy CP, which contributed to a widening of their spreads relative to the risk-free Treasury rate in September (see chart below).

Commercial Paper Outstanding

Furthermore, there was a significant shortening in the maturity of new CP issued with only the most trusted programs able to issue out as far as six months at favorable rates, resulting in many firms needing to roll over their paper every day (see chart below).

Commercial Paper Outstanding

In response to the deteriorating conditions, the Fed created the Commercial Paper Funding Facility (CPFF) in early October, which went operational yesterday (10/27). According to the Board of Governors, the new facility “is intended to improve liquidity in short-term funding markets and thereby increase the availability of credit for businesses and households.” The Board also said that “By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market.”

In the CPFF, the New York Fed will lend to a Special Purpose Vehicle (SPV) which will purchase eligible highly-rated (A-1, P-1, F-1) 3-month CP and ABCP from U.S. issuers. According to the New York Fed, the rate charged on unsecured commercial paper will be the three-month overnight index swap (OIS) rate plus 100 basis points per annum, and the rate for ABCP will be three-month OIS plus 300 basis points per annum. Additionally, for unsecured commercial paper, the New York Fed said “a 100 basis points per annum unsecured credit surcharge must be paid on each trade execution date.” Looking back before September, three-month CP rates typically traded very close to three-month OIS rates. The jump in CP rates in September led them to trade much wider than the SPV spread.

Commercial Paper Outstanding

Short-term debt markets have been under considerable strain in recent weeks as money market mutual funds and other investors have had difficulty selling assets to satisfy redemption requests and meet portfolio rebalancing needs. The CPFF is intended to support the issuers of CP by providing liquidity and supporting term lending in the CP markets. On Oct. 21, the Fed announced the creation of the Money Market Investor Funding Facility, which supplements the previously announced Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, to free balance sheets at money market funds and to encourage them to resume their traditional role in securities lending and participation in other financing markets. This will be the topic of Thursday’s blog.

By Mike Hammill and Andrew Flowers in the Federal Reserve Bank of Atlanta’s Research Department.